As the financial crisis fades into memory, no consensus has emerged on how things went so wrong. Some maintain that the Community Reinvestment Act and government-sponsored entities like Fannie Mae and Freddie Mac set in motion the chain of events that ended in disaster. Others blame two decades of unrestrained financial innovation for undermining the institutional and cultural safeguards of the free market. And then, of course, there are those who believe that all or some or none of these things are true.
What is beyond dispute, however, is that the banks that were deemed "too big to fail" in the heat of the crisis are even bigger now. The federal government's willingness to rescue the largest of the large financial institutions has given them an enormous edge over smaller competitors, a perverse outcome by any standard. Now that President Obama has succeeded in convincing Congress to dramatically expand federal subsidies for the purchase of private insurance coverage, the White House is shifting its attention to financial regulation. After a lively debate, the Obama administration and its congressional allies seem to have settled on an approach based around the Volcker Rule.
Named after former Federal Reserve Chairman Paul Volcker, its most prominent and committed advocate, the Volcker Rule would prohibit proprietary trading by bank holding companies. The idea has an intuitive appeal. The case for the Volcker Rule bears no small similarity to arguments made by economist Amar Bhidé, author of the forthcoming A Call for Judgment: Sensible Finance for a Dynamic Economy. Bhidé has argued that the centralization of the financial economy in a small handful of large financial institutions has undermined the free market. In Bhidé’s view, capitalism depends on the decentralization of judgment and responsibility. Centralized financial markets, in contrast, rely on mechanistic models and what Bhidé calls “blind diversification.” The decline of case by case scrutiny has resulted in a severe misallocation of resources. To correct these deficiencies, Bhidé calls for a complete regulatory overhaul of the financial sector, that would wall off “boring banks” from unregulated--and unprotected--financial institutions.
But the Volcker Rule has a number of potential downsides. Charles Calomiris of Columbia Business School, writing for e21, argues that it would devastate the U.S. financial sector: to meet the needs of clients, large global banks have to take positions in their own books. And if banks only engaged in just enough proprietary trading to meet the needs of clients, their clients would likely flee. Clients seek advice from sophisticated bankers who demonstrate their seriousness and their acumen through their willingness to put their knowledge of the market to the test by taking positions for the bank. For Calomiris, a Volcker Rule would amount to a "Volcker lobotomy" that would prompt clients to flee to banks based in countries with less onerous restrictions.
Then there is the question of whether the Volcker Rule is enforceable. In "Curbing Risk on Wall Street," an essay in the latest issue of National Affairs, Oliver Hart of Harvard and Luigi Zingales of the University of Chicago's Booth School suggest that clever financiers would have a very easy time getting around the restrictions. And so they focus on creating a different kind of regulatory regime, one that doesn't rely too heavily on the wisdom of rating agencies or the foresight of regulators to work.
To ensure that banks are capable of meeting systemically relevant obligations--the obligations that have to be met to prevent a system-wide crisis--Hart and Zingales would require that banks hold two layers of capital: a first layer of basic equity and a second layer of "junior long-term debt," which would only be repaid after debts in the first layer. This second layer of debt would be riskier and so would offer higher rates of return. Because this debt is explicitly labeled as a junior debt, investors would understand that no federal bailouts would be forthcoming in the event of a collapse. Investors would thus have every incentive to find out whether the bank was healthy enough to meet its obligations.
If investors sense that this junior long-term debt has become very risky, the price of insurance claims against this debt--that is, the price of credit-default swaps--would spike. Once a CDS price reached the danger zone, regulators would conduct a "stress test" of a bank's balance sheet. If the bank passes the test and is deemed adequately capitalized, it can go back to business as usual. If it fails, the regulator would put the bank into receivership, wiping out shareholders and giving creditors a "haircut," a reduction in the value of what they were owed. Taxpayers are spared.
The Volcker Rule has gained many adherents because of its apparent simplicity and the vague sense that it represents a more aggressive approach toward large financial institutions that a large and growing number of Americans detest. The Hart and Zingales is just as elegant, and it has the added virtue of having a fighting chance of actually working.